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The Yield Curve

The yield curve is a chart that depicts the relationship between interest rates and maturity dates on US Treasury bills and bonds. The curve deserves special attention, because of its unique ability to forecast the economy and thus bond prices. Many individuals believe the popular view that interest rates move in tandem. In practice, however, rates move somewhat independently, varying by maturity.  In recent history, the Fed tried to slow down the economy, mainly the housing sector, by increasing short-term interest rates, only to find that market forces decreased longer-term rates. It was called “the conundrum.” That is the history of the yield curve; you never know how it’s going to behave.

The changing shape of the yield curve is critical to bond investors, because it will affect some bonds more than others, depending on their maturity. If rates for a particular segment of the yield curve increase, then bond prices for that maturity niche will decrease.

Normally, however, the longer the maturity on debt instruments, the higher the interest rates. It makes sense; the longer one’s money is outstanding, the higher the degree of risk. As such, investors need to be compensated for the extra risks they are taking. This relationship, (the longer the maturity the higher the rate), is reflected in the normal yield curve. Naturally, nothing works as planned; as a result, over time, we have developed four different main yield curve patterns to help us understand how interest rates affect the economy, our investments, and where rates are heading. They are:

Normal Yield Curve

Steep Yield Curve

Flat Yield Curve


Inverted Yield Curve

1.      Normal Yield Curve

Investors receive progressively higher interest rates on their bonds as the maturity dates increase. It’s normally expressed as a yield curve that slopes upward to the right. It’s also a sign of a healthy economy. Banks love this type of interest rate environment; they can borrow short-term money at low rates, loan out longer-term money at higher rates, and earn the spread as profit. While bankers would say asset liability management is much more sophisticated than that comment, in a normal yield curve environment, it is that easy. The expectation of increasing short-term rates has also been credited as a major factor for a normal yield curve chart.

2.      Steep Yield Curve

As a general guide, long-term rates exceed short-term rates by over 3 percentage points (300 basis points). A steep yield curve, like the normal yield curve, slopes upward to the right, except the slope of the line is steep. Typically, a steep yield curve develops after a recession, in the recovery stage, when demand for money picks up. Investors are afraid that they could be locking in low returns as rates increase. Consequently, they quickly move into longer-term maturities, demanding much higher returns, and causing a steep yield curve. As short-term rates gradually increase, the curve naturally normalizes. In a stable rate environment, however, a steep yield curve can also present interesting opportunities. The “rolldown” is a popular investment technique.  Using a five year bond as an example, after one year the bond would be a four year bond. As the remaining term declines, the bond will “rolldown” the yield curve, and the bond’s price will appreciate in value. The bondholder will also receive interest as he/she waits for the bond to increase in value.

3.      Flat or Humped Yield Curve   

Short-term and long-term rates are similar. Normally, the middle may have a small increase; thus, the term “humped curve” was developed. Many experts believe that a flat yield curve can be a signal for an upcoming slowdown in the economy.

4.      Inverted Yield Curve

Short-term interest rates are higher then long-term interest rates.  The yield curve slopes downward to the right. New long-term investors are betting that short-term rates will come down. Inverted curves are somewhat unusual, and are typically followed by an economic slowdown or even a recession. When the yield curve changes from a normal curve, to a flat yield curve, to an inverted curve, existing long-term bond holders typically do very well. As long-term interest rates drop, the price of long-term bonds will appreciate in value.

Yield Curve Theories - Yield curve curiosity has spawned many theories, including the following:

Yield CurveTheories

1.      Expectation hypothesis – A market approach view towards interest rates; the yield curve depicts where investors believe interest rates are heading. Furthermore, long-term interest rates will equal the average of future short-term interest rates. If the yield curve, for example, is heading upward, then short-term rates are expected to rise. Conversely, if the yield cure is inverted, short-term rates are expected to decrease.  

2.      Liquidity preference hypothesis – The belief that “cash is king,” and that investors demand an extra return (liquidity premium) the longer their money is tied up. The more liquid the investment, the lower the rate.

3.      Market segmentation hypothesis – Concludes that the interest rate market is fragmented, and that each segment has different lenders and borrowers. The participants have specific cash flow preferences, revolving around the maturity requirements of their industry.  Each segment, therefore, has its own distinct market, demanding specific rates, credit ratings and maturity terms.

In summary, the yield curve guessing game is very interesting and complex, with many pitfalls.


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